by David Bassanese
Australian Financial Review
The decline in the Australian dollar over the past month has brought some relief to the long suffering trade exposed sectors of the economy. But it begs the question: can the Aussie still be considered overvalued, and has the decline to date been enough to obviate the need for a further official interest rate cut?
Let’s tackle the overvaluation question first – as it will shed light on the outlook for interest rates. Thanks to a freedom of information request earlier this year, we know a little more about how the Reserve Bank of Australia tries to assess the Aussie’s fair value due to the release of internal research reports. The RBA “preferred model” for the exchange rate is based on a statistical regression equation explaining the real (inflation adjusted) trade-weighted exchange rate index since 1986 against the terms of trade and real interest rate differentials.
The latter compares the real cash rate in Australia against the “G-3” average (ie the United States, Japan and Germany). To explore the model’s implications in more detail, I've replicated it here at The Australian Financial Review. Using quarterly data, the model appears quite good, with an ability to explain 93 per cent of the changes in the real exchange rate index over the past 27 years. As it is more closely watched, however, I've used the above methodology to focus on a fair-value model for the Australian-US dollar nominal bilateral exchange rate. To estimate the nominal exchange rate, I've let relative inflation be one the explanatory factors, along – as above – with the Australia-US real short-term interest rate differential and the terms of trade.
The model results are similar to those using a broader real exchange rate measure.For starters, it suggests a 10 per cent increase in the terms of trade should be associated with a 7.5 per cent increase in the nominal exchange rate, and a 1 percentage point change in the real interest rate differential will change the nominal exchange rate by 2 per cent.
Nominal rate adjustments
The model also suggest the nominal exchange rate fully adjusts over time to negate inflation differentials – if prices in Australia increase by 10 per cent more than those in the United States, the nominal exchange rate should depreciate by around 10 per cent. All up, the model explains 80 per cent of the quarterly movement in the nominal exchange rate since 1986. So far so good, so what does this model tell us? It suggests that in the March quarter the Australian dollar’s fair-value was around US 88¢ – or 17 per cent above its long-run (since 1986) average of US 75¢.
To understand how we arrive at this valuation, we can break down the model results into its constituent parts.
- First, and contrary to claims that high local interest rates have helped push up the Australian dollar, note the real interest rate differential was a bit below its long-run average last quarter.
- Since 1986, the real cash rate differential against the United States has average 1.8 percentage points – and last quarter it was only 1.6 percentage points.
- Interest rates have been a neutral factor on the exchange rate’s level – relative to its long-run average – since mid-way through last year.
- Meanwhile, Australian underlying consumer prices have increased by around 36 per cent more than in the US since 1986, such that Australia’s relative price level to the US price level in the March quarter was 14 per cent above its long-run average.
- Higher relative inflation has acted to push down fair value for the nominal exchange rate over time.
- Indeed, if the terms of trade were equal to their long-run average last quarter, fair-value for the nominal Aussie would have been around 12 per cent below average – at US66¢.
- Of course, the terms of trade were still 46 per cent above average last quarter – which would push up fair-value for the Aussie by 33 per cent relative to its long-run average.
The net result of this two countervailing forces – higher inflation but also a higher terms of trade – is that fair value for the Australian dollar was around US88¢ last quarter, or 17 per cent above its long-run average. Instead, the Aussie averaged $US1.04 – or around 18 per cent above its fair-value estimate.
Of course, in recent weeks the Aussie has fallen to US96¢, or around 7.5per cent from its March quarter average. That said, while interest rates and relative price levels have not changed by much – the terms of trade look likely to fall back this quarter given that iron ore prices have so far averaged 14 per cent below their March quarter average.
Indeed, the Federal Government’s budget time forecast for a 7.5per cent decline in the terms of trade this financial year seem ever more unlikely, as it would require an improbable 11 per cent terms of trade rebound this quarter.
Either way, if we plug in a 5 per cent decline in the terms of trade, fair value for the Australian dollar drops to around US84.5¢ this quarter, implying it remains 14 per cent overvalued even at its latest level around US96¢.
All up, however, although the Aussie has eased in recent weeks, so to have iron ore prices – suggesting its remains close to level of overvaluation evident last quarter, during which time the RBA cut interest rates.
It’s why I feel the RBA is still likely to cut interest rates in coming months unless the Australian dollar drops to at least the high US80¢ range.